With U.S. home price appreciation accelerating to levels reminiscent of the run-up to the global financial crisis (GFC), some fear another housing market bubble. While home prices are up 15% from a year earlier, this isn’t a repeat of 2008. In fact, the enduring strength of the U.S. housing market presents compelling opportunities for those looking to diversify their fixed-income holdings.
Year-over-year change in the price of U.S. single-family homes (%)
This isn’t 2008
Housing bubbles are typically driven by speculation and easy lending standards. The environment today, however, has little in common with the 2007/2008 crisis. Rather, the rise in home prices is largely a result of a long-standing mismatch between supply and demand.
Record-low inventories of existing homes
Beginning in mid-2007, as the U.S. housing bubble deflated, millions of homes were foreclosed on and existing home inventory climbed to multidecade highs. Many households turned to renting, single-family home construction activity slowed significantly, and some builders went out of business. In 2010, as the economic recovery began to take shape, existing home supply began to decline from record highs as retail and institutional investors identified the housing market as a lucrative investment opportunity.
For many households, renting remained the norm until the economy accelerated in 2017. Single-family home demand strengthened as some households decided to shift back to home ownership while inventory declined because of the shortage of new construction in prior years.
New housing starts across the United States
Over the last several years, demand for single-family homes has increased amid low mortgage rates and strong economic growth. Meanwhile, limited availability of land, labor, and building materials has slowed construction activity, especially of entry-level homes. As of the fourth quarter of 2020, the U.S. housing market was facing a shortage of 3.8 million units.
U.S. existing home inventory and months of supply
A rising generation of buyers is entering the market
While the pandemic also created additional demand for homes in suburban markets, there’s a longer-term demographic force at play that will likely keep the upward pressure on home prices.
Some 72 million millennials across the United States are now in their peak first-time home buying years. A recent analysis by Freddie Mac estimates that the sheer size of this demographic cohort and the chronic undersupply of housing could keep the demand for entry-level single-family homes high throughout the rest of this decade.
Addressing higher rates
While the outlook for housing demand is positive, risks reside around home affordability. With the economy on strong footing and inflation rising, the U.S. Federal Reserve (Fed) has embarked on a path of interest-rate hiking that's seen mortgage rates increase from multi-year lows. The Fed, however, has been transparent in telegraphing its intentions. Even though higher mortgage rates may force some prospective buyers out of the market, the long-term housing and economic fundamentals remain sound. While higher mortgage rates may slow down the pace of home price appreciation, we don’t believe home prices will depreciate, barring an exogenous market event.
The market has been revamped, and loose lending standards are gone
The U.S. market for securitized assets stands at $13 trillion1 and, despite its enormous size, it's often underallocated by investors who focus on more traditional bond sectors. Perhaps some of this may be related to lingering hesitation given that market's role in the housing crash of 2007/2008.
Since the GFC, significant legislative measures have meaningfully reformed the financial industry. Many of the risky mortgage products that contributed to the crash no longer exist; in fact, many mortgages being created today are 30-year fixed-rate amortizing loans. Banking and lending reforms have also led to new regulations to protect borrowers against aggressive lending practices. Borrower risk is significantly lower today with tightened requirements such as higher credit scores, lower loan-to-value ratios, and lower debt-to-income ratios. As a result, the total mortgage market default risk is low relative to history.
Default risk taken by the mortgage market
Loan underwriting and security issuance standards have also improved to align the interests of both security issuers and investors of mortgage-related products.
Attractive opportunities across a variety of mortgage-related securities
Investors looking to increase exposure to residential real estate may consider a strategic allocation to a diversified portfolio of agency mortgage-backed securities (MBS) and nonagency MBS—investments issued by private entities.
The nonagency MBS market is somewhat fragmented and consists of multiple subsectors that may offer opportunities across:
- Agency credit risk transfer securities (CRT)—These provide an opportunity to invest in the full spectrum of mortgage credit from investment grade to high yield. While CRTs aren't guaranteed by government agencies, their underlying loans benefit from the same sound underwriting practices as agency MBS.
- Nonqualified mortgage securities (non-QM)—The underlying loans in these securities are originated by non-bank lenders. While these mortgages may be undertaken by those facing credit challenges, they aren’t subprime loans. Non-QM mortgages are underwritten with high standards, requiring various income and asset standards for approval. While these securities carry slightly higher credit risk, they offer opportunities to capture an additional yield spread.
- Single-family rentals—Securities in this sector provide an opportunity to invest in institutional ownership of residential homes with the purpose of renting. Properties are located in cities and towns across the United States that benefit from population growth, job growth, above-average GDP, strong home price appreciation, low crime, and strong school systems. These securities benefit from the stability and growth of rental income.
Consider an active approach to uncover undervalued securitized assets
While investors have options on how to invest in securitized assets, due to their perceived complexity, many of these securitized subsectors receive less attention from market participants and can be less efficient. We believe this creates opportunities for active managers with bottom-up expertise to analyze these securities and identify undervalued assets.
We believe positive fundamentals in the housing market such as limited supply, demand from a rising generation of millennials entering their home-buying prime, and conservative underwriting practices are supportive of securities that benefit from the strength of residential real estate markets. Consider an actively managed approach to diversify investment portfolio holdings.
1 SIFMA, Barclays, J.P. Morgan, as of June 30, 2021.
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